PORTFOLIO CONSTRUCTION AND INVESTMENT STYLE

Once our clients’ investment objectives have been established, Milestone’s next step is deciding which asset classes and what allocations of each should be used to reach those goals. Studies indicate that these decisions will have the most impact on the variability of portfolios over time, so our investment approach is rigorous and disciplined.

Here we summarize our approach for evaluating each component of asset mix:

Equities – We allocate and manage equities according to six criteria:

1. Geography – We categorize equity positions into Canadian, US, Non-North American Developed

and Emerging Markets. The Canadian component is usually the largest, given the tax advantages of

Canadian dividend income and our desire to moderate currency risk. A substantial position of US

stocks is also held, given the depth of that market and its attractive risk-reward characteristics.

Emerging Markets are given the lowest weighting because of the inherent risk of this class, usually

representing 10% of total equities.

2. Capitalization – We believe all equity investors should have both large and small company

holdings in their portfolios (often referred to as large-cap and small-cap). The core of equity

investments is in large-cap holdings, but history illustrates small-cap representation boosts returns

with only small increments in the portfolio’s risk profile.

3. Investment Style – Stocks can be viewed as those with high book values relative to their share

price (value stocks) and those with low book values relative to their share prices (growth stocks).

Although we believe equity investors should have exposure to both types, strong evidence

supports the outperformance of value stocks relative to growth stocks over time. For this reason

we emphasize value stocks to attain higher expected returns.

4. Investment Approach – Strong evidence shows it is very difficult for individual investors to

outperform entire markets on a long-term basis (see our commentary “Mutual Fund Performance”).

With this in mind, we use low-cost Exchange Traded Funds (ETFs) and DFA institutional funds as

the core component of equity portfolios. These provide exposure to a large percentage of an entire

market and deliver considerable tax benefits for the long-term investor (see our commentaries

“Asset Location”, “Strategies to Minimize Tax”).

5. Profitability – Given the choice between two stocks with identical Price-to-Book ratios and market

capitalization, investing in the company with higher gross profitability may lead to higher returns.

6. Stock Selection – We invest a portion of our Canadian equity exposure in high-quality, “blue chip”

stocks offering attractive, secure and growing dividends over time. In many cases, these currently

provide dividend income in excess of interest on cash reserves and short-term bonds. With the

benefits of the dividend tax credit, after-tax income is further enhanced relative to a bond

counterpart. As time passes, this gap expands. For example, someone invested in bank stocks over

the last 10 years is now receiving over 11% in dividends relative to their initial cost - due to dividend

increases. A comparable bond would have to yield over 15% to provide the same after-tax income

for an investor in the highest tax bracket. This illustrates that stocks can be purchased for income

as well as capital gains, particularly for long-term investors. Our focus is therefore on yield, along

with the growth prospects and the safety of dividends, rather than outperforming the Canadian

market. We also gain broad based exposure to the Canadian market through DFA funds with a tilt

toward small-cap, value, and profitable stocks.

Additional equity investments include REITs (Real Estate Investment Trusts). These investments

enhance income, provide tax advantages and improve overall portfolio diversification. Our focus in

this area is safety, so we emphasize diversification and quality to improve the likelihood of superior

returns.

Fixed Income – This asset class serves three purposes. First, it provides a steady income stream if a

client needs it. Second, it provides stability to the portfolio during weak equity markets. In addition, it

can act as a counterbalance to other classes, providing impressive returns during unsettling times –

bond prices tend to go up when stock prices go down.

Our style is low-risk, with the objective of providing income and security even in the most serious

recessions. We do not think risk is well rewarded in the bond market, unlike the stock market.

Therefore, we invest the core of a bond portfolio in the highest-quality bonds, keeping maturities

relatively short and staggered. Government-backed issues with maturities less than five years comprise

most of this asset class. A small percentage of non-cyclical, high-quality corporate bonds may be

included to increase yield. Real return bonds, hedged foreign bonds and preferred shares, where we

take some risk for higher returns, play a tertiary role in the fixed income portfolio.

Cash Reserve – Our clients receive attractive rates on so-called ”investment savings accounts”,

essentially money market funds without MERs offered by Royal Bank, TD, Bank of Nova Scotia and the

like. This rate is comparable to most money market instruments but we also buy high–quality, short-

term bonds (under one year) if their rates are higher. Cash reserves sometimes help returns in the short

term, but over longer periods of time they drag down portfolio performance, so as a rule they should

be kept to a minimum.

We are confident that our investment style and our disciplined process of constructing portfolios helps

us deliver to our clients the best possible after-tax returns for the lowest level of risk.